THE BLOG
03/06/2015 05:50 pm ET Updated Dec 06, 2017

Hedge Fund Win-Win Fee Model -- Innovative and Fair in Many Respects

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The innovative Hedge Fund Win-Win Fee Model takes a different approach to client fee charges. It creates a more balanced win-win partnership between hedge funds and investors.

The hedge fund win-win fee model is not a certificate but an innovative, simplified, straightforward, and intuitive win-win fee model.

Thus, the new model aims to overhaul the fee structure policy of the hedge fund industry (hedge funds and funds of funds).

The fees of hedge funds are, in general, perceived as too high; therefore, more and more investors question the status quo.

Most hedge funds charge management fees of 1-2 percent of assets under management and, in addition, performance fees of 20 percent.

Some fund managers have started offering lower fees, but this usually happens only when investors agree to commit their money for a longer investment lock-up period.

The hedge fund investment industry seems very hesitant to provide customers with truly innovative fee schemes.

With the new win-win fee model, the fund guarantees a refund of a portion of the total fees (management and performance fees) if the investor suffers a loss or a predefined return target is not reached. In return, the investor must commit in advance for a certain lock-up period.

In general, only weak or new fund managers tend to offer reduced fee models that deviate from the industry 2/20 fee structure.

However, the win-win model should also be an attractive business model for established hedge funds since it does not cause any reduction of the usual fee income if they achieve a positive return.

If a fund manager believes in his ability to generate alpha (risk-adjusted excess return relative to a benchmark), and the investor commits to staying invested for a predefined period in the fund, then you can really talk about a win-win situation.

Furthermore, it weakens the argument by investors that if they lose money the managers do not suffer along with them.

There are also other very good reasons for the alternative investment industry to seek out new fee business models

First, there is the great popularity of inexpensive index funds and FinTech companies that provide robo-advice. Even Warren Buffett recommended that, after his death, his trustees invest 10 percent of his cash in short-term government bonds and 90 percent in an inexpensive S&P 500 index fund.

Secondly, another threatening trend was started in 2014 with, CalPERS's, the largest US pension fund, decision to pull out from hedge fund investments. The reason given was that hedge funds are too complex and too expensive. CalPERS's decision has led many institutional investors to reevaluate their commitment to the alternative asset class.

There are perhaps some readers who will argue that the fee model is the same as a clawback clause or performance fees.

This is not the case. The difference is best seen in a comparison between these models and the win-win model.

A comparison of the clawback clause and the win-win fee model

Some institutional investors tried to convince hedge fund managers to accept a clawback provision, which is quite normal with closed-end funds (private equity, venture capital, real estate, and natural resources). In other words, hedge funds would have to refund the already paid performance fees if the gains would prove in the following years as not sustainable; these efforts are met in the hedge fund industry with great resistance and low acceptance.

Some hedge fund managers do perceive a clawback clause as a good idea, but this is just to make sure that they have the possibility to clawback any bonus payments that have been made to their managers, who, in retrospect, did not deserve this because of illegal actions. Thus, the clawbacks are seen as a self-defense instrument to pay any potential legal fees, damages, etc. and not, in order to protect investors from overpaid fees.

If we look at the first case, where the clawback approach serves the interests of investors, two essential differences are significant to the win-win-fee model.

First, the win-win-fee model will only refund part of the paid fees, and secondly, the refund includes not only the performance fees but also the management fees.

Furthermore, only with the hedge fund win-win model is the refund rate of the respective investment commitment period set from the start. This does not mean that the investor cannot get out sooner or remain longer invested. However, the win-win obligation of the hedge fund to the investor will, in both mentioned cases, cease unless agreed upon otherwise.

Comparing the performance fees and the win-win fee model

Hedge funds charge a performance fee on realized or unrealized gains. However, unlike with the win-win model, in this case, investors will never receive any refund of fees paid.

Furthermore, the potential refund of the win-win fee model includes not only the performance fees but also the management fees. The win-win model ensures a fairer protection of investors' interests.

With the win-win-fee model, all will benefit - clients and hedge funds

Investor advantages:

  • Increased confidence that the fund manager will make an even stronger effort to generate positive returns.
  • A potential loss cannot be entirely compensated, but it will be reduced.
  • A potential refund can increase the overall performance of the portfolio.

Hedge fund advantages:

  • The fund management's credibility to deliver results increases.
  • Investors will remain longer invested in the fund, and, therefore, the fee income will be more predictable.
  • Gain new customers, and retain existing customers.

The opportunity to establish itself as a leader in the new and innovative hedge funds win-win market segment is very attractive and large.

"Price is what you pay. Value is what you get."
- Warren Buffett

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